Supermarket loyalty cards and giant out-of-town stores will not be powerful
enough to halt the rise of the German discount retailers

Tesco owned the world," Charlie Munger, Warren Buffett's right hand man at Berkshire Hathaway, said last month. "And one day it stopped working so well."

When Buffett started investing in Tesco in 2006, Britain's biggest retailer was at the peak of its powers. It accounted for more than 31pc of the UK's grocery market, taking one pound in every seven spent in our shops.

The only criticism seemed to come from local communities and campaigning groups that were concerned the retailer was becoming too dominant. The phrase "Tescopoly" was born and the Competition Commission launched an inquiry.

Tesco's management, however, were dismissive. "The reason we are big is that over the years customers have chosen Tesco," Sir Terry Leahy, the former CEO, said.

Buffett, attracted by Tesco's dominance in the UK and its exposure to emerging markets in Asia, built Berkshire's stake in the retailer to almost 5pc. The company could seemingly do no wrong and on New Year's Eve, 2007, the share price reached a record high of 477.25p.

But the "Sage of Omaha" is not the only well-known investor to be nursing wounds from the implosion of Britain's supermarkets. Qatar Holding, one of the world's biggest sovereign wealth funds, is sitting on paper losses of more than £1.5bn from its stake in Sainsbury's.

So far in 2014, the food retailers are leading the FTSE 100 downwards. Tesco is down 47pc, Morrisons has lost 39pc, and Sainsbury's has fallen 38pc.

The supermarket industry appears to be undergoing its own version of the banking crisis.

Bryan Roberts, retail insights director at Kantar Retail, said: "Tesco doesn't just compete with Sainsbury's, Asda, Aldi and so on. There's millions of shoppers buying what we refer to as groceries from diverse places such as Staples, Poundland, Wilkinson, Costco, Superdrug and Amazon.

"Never before has there been such a plethora of choice, and never before have shoppers been so willing to exercise that choice."

With online retailing becoming increasingly sophisticated, supermarkets still opening out-of-town stores and convenience shops, and German discounters targeting the UK, consumers are inundated with choice.

This increase in choice has combined with a willingness to use it.

Mike Watkins, Nielsen's UK head of retailer and business insight, said: "The economic factor driving behaviour from "big and occasional" to "little and often" is saving money – its easier to manage weekly than monthly budgets and reduce wasted food.

"This is compounded by a key lifestyle factor, shopping online, which reduces the need to go out-of-town."

Suddenly, with Tesco not the only shop in the village anymore, customers who once spent £90 a week in Tesco now spent £30 at Aldi, £30 on an online shop at Ocado or Waitrose, and £30 in Tesco. At the same time, they started buying non-food items from Amazon instead of Tesco.

Mike Coupe, chief executive of J Sainsbury, conceded last week that shoppers have never been "savvier or shopped around more". Extraordinarily, Morrisons says it has attracted more shoppers through its doors in the last year, despite sales falling sharply.

Until 2014, the pressure on Tesco and its rivals, particularly at their out-of-town stores, was masked by food price inflation, which helped to ensure that sales continued to rise. However, this year the strengthening of sterling and strong global harvests dragged down the price of fruit, vegetables and wheat. With Aldi and Lidl gaining more shoppers, the "big four" – Tesco, Asda, Sainsbury's and Morrisons – had no option but to lower prices.

Consequently in 2014, the grocery industry is seeing price deflation for the first time on record. The effect on sales has been eye-watering. Tesco's like-for-like sales are falling at the fastest rate for 40 years; Sainsbury's sales are down for the first time in a decade and Morrisons' like-for-likes dropped by an unprecedented 7.4pc in the half year to August 3.

Overall sales in the grocery industry rose by just 0.3pc in the 12 weeks to September 14, according to Kantar Worldpanel – the lowest number since it started compiling data in 1993.

But not everyone is losing sales. Aldi grew sales by 29.1pc year-on-year in the past 14 weeks, while Lidl grew by 17.7pc.Sales for upmarket food retailers Waitrose and Marks & Spencer are also growing.

The big four still hold 73.3pc of the grocery market but a year ago it was 75.2pc. This contraction is equal to the loss of £404m of sales across 12 weeks. At the same time, Aldi and Lidl have grown their combined market share from 6.7pc to 8.3pc, which is worth £396m of sales.

It is not difficult to see where the big four are losing sales. After first arriving in the UK in the early 1990s, German discounters Aldi and Lidl have developed their model and now know how to attract British shoppers. They have based their offer on providing shoppers with consistent prices and British-sourced fresh food.

Matthew Barnes, joint managing director of Aldi, said: "Customers have come to see Aldi as a business they can trust, potentially in a market where there is very much a lack of trust."

The City has now woken up to the challenges facing Tesco, Sainsbury's and Morrisons, the listed grocers, and their shares have taken a hammering. Investors are concerned at the loss of sales but also how much it will cost to put right. Margins, profits and dividends are going to fall sharply. Tesco has already cut its dividend by 75pc, while Morrisons has reduced its profits by half this year to fund price cuts and a new loyalty scheme.

Rights issues could also be on the horizon to shore up balance sheets. Tesco is a lumbered with a £2.6bn pension deficit and £16bn of lease commitments after selling off supermarkets to property fund managers.

Clive Black, analyst at Shore Capital, said the discounters had enjoyed a "free lunch" over the past few years as the traditional supermarkets look to protect their margins, providing a gap for Aldi and Lidl, but that this was coming to an end as the big four are changing strategies.

Dalton Philips, chief executive of Morrisons, says the industry is heading for a "commoditisation of prices". The company's new "Match & More" scheme pledges to match the price of a basket of goods at Tesco, Sainsbury's and Asda – but also Aldi and Lidl. "There are huge structural shifts going on in the market," he said.

The UK supermarket industry began in 1950 when Sainsbury's opened its first self-service supermarket in Croydon. Before this, shoppers had ordered their food from counters. The new system allowed retailers to open bigger and more efficient stores.

This sparked the rapid expansion of Tesco, Sainsbury's and, eventually, Asda and Morrisons, across the UK.

By the first decade of the 21st century, Tesco had reached every postcode in the UK . During this era, Tesco's strength was its property team. It opened more stores than everyone else and has more than 3,000 stores in the UK today.

However, once you are in every postcode, where do you go next?

Meanwhile, Tesco's rivals are catching up by opening more stores and developing internet shopping.Gradually, the playing field has levelled.

Black describes it as the "age of democracy". This era is one where the location of stores and the loyalty programmes such as Clubcard – hailed as the key to the success of Tesco under Sir Terry – are less valuable. Instead, shoppers are judging retailers by the basic quality of their products and prices. The "big four" are not doing enough to win.

"Alongside Morrisons, the two supermarkets in the UK that are performing most poorly at present are Sainsbury's with its Nectar card and Tesco with Clubcard," Black said.

"More to the point the loyalty element of these initiatives seems to be virtually nil at the present time, given their respective sales performances, and we would not be surprised if Clubcard and Nectar were possibly amended. Neither Aldi nor Lidl have loyalty programmes and continue to materially outperform.

"They just have the most simple offer possible – that is low prices, limited promotions, few vouchers and coupons and no loyalty schemes."

In such an environment, is it even possible for one retailer to hold almost a third of the market, as Tesco does, or even 16pc, as Sainsbury's does?

Tesco's attempts to protect its position have led to the retailer unravelling as sales have fallen. Clarke was ousted as chief executive in July, and then a £250m shortfall was discovered in the company's profits.

The investigation into the black hole is focusing on the culture at Tesco, amid fears that increasingly stressed managers and staff may have been bullied into crossing lines.

One senior source said there may have been a "corruption of virtues" among staff.

A former executive said Clarke was an "intense" personality. "He gets very close to you when he talks, almost like he is going to headbutt you," they said.

Industry forecasts suggest the environment will get even harder for the supermarkets. IGD, the industry research body, has said that within five years the combined sales from convenience stores, discounters, and the internet will be larger than in traditional supermarkets and hypermarkets.

Richard Hyman, chairman of George Bailey, the customer insight consultancy, said: "In my opinion, this is structural. I can't see anyone again exerting the dominance Tesco has.

"There has been a very benign competitive background in UK food retailing for many years. I am categorically not saying prices have been fixed, merely that there has been sufficient growth for the key players to mop up, whilst making very good margins.

"The growth bit has changed – all but disappeared, for the majors at least. And it will not return, not in the way it has been for decades."

Hyman said the big four had been guilty of "spectacular arrogance" by "thinking their customers wouldn't be seen dead in an Aldi or Lidl".

He added: "Consumers are realising that, to a degree, they have been taken for granted. Food retail is a business that has always tended to pay lip service to the idea of customer knowledge. To a material degree, they have actually been the architects of their own problems."

Neil Saunders, managing director of Conlumino, added: "The other point is that the playing field has now been levelled. Previously, to acquire a high share, retailers needed to invest in property – that's expensive and represents a high barrier to entry. The same is true today, but only to an extent. Online has made it easier for all players to acquire and reach more customers."

Saunders insisted that the decline of the big four was not about a dislike of big business.

"Some people make that claim but, in my view, I think it misses the point," he said. "While people may say they dislike big firms, most shoppers rarely act on their beliefs and end up shopping at stores that best suit the needs. As such, Tesco's decline came about because it stopped delivering what consumers wanted. Aldi and Lidl have done well because they are more in-tune with what consumers want.

"Arguably, if consumers were genuinely concerned about big firms they would not switch their custom to the deep discounters – both of which are very big companies. As for the big four, I do think they will see further declines – but that's mostly because, with such a high collective share, the market is theirs to lose."

Sir Terry's words in 2006 now haunt the retailer. It is not doing enough to protect its huge market share anymore and being a "Tescopoly" has gone from being a strength to leaving Tesco with nowhere go.

Tesco certainly "stopped working so well", as Munger said, and that has opened the door to new rivals.